Don't Put All Your Eggs In Two Baskets

"Playing with the stock market is like playing chicken with a freight train - no matter how many times you win, you only get to lose once." - Mike Masters profiled in Stock Market Wizards

What does it mean to have a truly diversified portfolio? Diversification means many things to many people. Some people think they are diversified if they hold more than a handful of stocks spread across different styles, sectors and countries. Others might think they are diversified because they have a mixture of stocks and bonds. In actuality, an investor could hold thousands of stocks and bonds in a portfolio and still be missing out on ample opportunity to achieve an even more efficient level of diversification.

True diversification is more about the correlation of assets, or how they move in relation to each other, than it is about the sheer number of holdings in a portfolio. Stocks, for example, experience a high degree of correlation across styles, market caps, sectors, regions, etc. Thus, having “more of the same” doesn’t add meaningful diversification since a rising tide lifts all boats (and vice versa if the tide is lowering). In a strong down market holding thousands of different stocks won’t protect an investor from experiencing deep losses. Consider the tech bubble or more recent financial crisis as examples of periods in which all stocks were headed in the same direction.

Investors who want diversification from the broader equity market won't necessarily get it via real estate. What they might get is more risk.

Our takeaway was actually the counterpoint to the article’s conclusion that publicly-traded real estate funds known as REITs (Real Estate Investment Trusts) should be added to a portfolio for income and diversification benefits. Since REITs are bought and sold like other equities and are included in major equity indexes like the S&P 500, they act very similar to stocks, especially during turbulent periods as shown in the embedded chart.

Digging a little further into the numbers reveals that VNQ acts a lot like a high beta version of the S&P 500. Table 1 breaks down the correlation and risk statistics for the Vanguard REIT Index ETF (VNQ) versus the S&P 500 ETF (SPY). The REIT ETF is highly correlated (80%) to the broader equity market with more risk as measured by volatility, worst 12 months, and maximum loss. It does compensate the investor for the additional risk by delivering a higher return than the S&P 500. The return per unit of risk is slightly better than SPY, which is summarized in the Sharpe ratio and the fact that the up return capture is larger than the down return capture. But because the two assets are so highly correlated, the diversification benefit of holding both assets in a portfolio is minimal.

One way to test for diversification is to see whether the expected volatility of a portfolio would be reduced by adding incremental amounts to a new asset. Using the return, volatility (standard deviation), and correlation numbers from Table 1 and plugging them into this very handy Two Asset Portfolio Calculator, we see that the expected portfolio return and risk increases as the allocation to VNQ increases. If we change the correlation coefficient from 0.8 to 0.2, we see that the expected standard deviation of returns actually drops to its lowest point when there is an 80% allocation to SPY and a 20% allocation to VNQ. The expected risk and return profiles are shown in the chart below.

An asset with the same volatility as VNQ but with much less correlation (20% vs. 80%) to SPY adds diversification to the portfolio by increasing expected returns while decreasing expected volatility. Risk return charts that are linear and resemble a straight line, such as 80% correlation line, show very little diversification benefit is being achieved. Risk return charts that push "up and to the left," such as the 20% correlation line, are indicative of a real diversification benefit. If adding an asset to a portfolio doesn’t reduce the risk, then it isn’t providing much of a diversification benefit.

This is why we coined the phrase Diversification 2.0 to explain our approach to building truly diversified portfolios. Our approach to portfolio construction goes beyond just stocks and bonds by including a meaningful allocation to commodities, absolute return strategies and currencies/gold. The inclusion of these three asset classes increases the investable universe, reduces the inter-dependencies of assets in the portfolio (e.g. correlation), and provides multiple return profiles that are being independently driven by unique macro and micro factors. The end goal is to produce a more consistent return stream with less risk.

Compounding higher returns with less risk is what is known as moving “up and to the left” on the risk/return spectrum. There is no guarantee that the future will look anything like the past or that a Diversification 2.0 portfolio will outperform the classic 60/40 stock-bond blend, but we would rather spread our eggs across multiple baskets than concentrate them in a two asset portfolio. In doing so we believe our clients are better positioned to meet return objectives with less downside exposure over time.

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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.